When you start planning a construction project, you need to consider the financing strategy for the project as part of the process. The size of the project you can undertake will be directly influenced by the amount of money available. This is one key reasons why we are interested in understanding your target investment and financing strategy when we start working with you.
Depending on your financial situation and the nature of the project, there are several options available. If you have a lot of equity in your home, you can use one of the financing options that is based on the CURRENT value of your home (Current Value Financing). If you are buying a new property, or don't have a lot of equity in your property, you often can only qualify for the options that are based on FUTURE value of the project (Future Value Financing) -- what it will be worth when completed.
Financing options are presented here in generally increasing cost of capital.
If you have the money for your project available through personal savings, inheritance, or from another source, it is the simplest vehicle for paying for the project.
Current Value Financing
Qualification for these loans is based on the appraised current value of the property, the value BEFORE the work is completed.
Home Equity Line of Credit (HELOC)
HELOC stands for home equity line of credit, or simply "home equity line." It is a loan set up as a line of credit for some maximum draw, rather than for a fixed dollar amount. Using a HELOC , you receive the lender’s promise to advance you up to $150,000, for example, in an amount and at a time of your choosing. You can draw on the line by writing a check, using a special credit card, or in other ways. For remodeling projects, most HELOC's are second mortgages. HELOCs have a draw period, during which the borrower can use the line (usually 5-10 years), and a repayment period during which it must be repaid (usually 10 to 20 years). Some HELOCs come due all at once at the end of the draw period.
A cash-out refinance is a replacement of your existing mortgage with a larger one that provides cash for the project. This approach usually requires enough equity so that the new mortgage is still no more than 80% of the home's CURRENT value. A cash-out refi makes the most sense when current interest rates are less than your current mortgage. If your current mortgage is at a lower rate than currently available, it probably makes more sense to take out a home equity loan.
Future Value Financing
Underwriting for these kinds of loans is based on the appraised future value of the property, the value AFTER the work is completed. Consequently, a schematic design and a preliminary construction estimate for the project are required before this kind of loan can be evaluated by the lender. There are a number of different kinds of loans that fit this category. There are listed below in generally increasing order of cost of capital.
A construction loan is funding provided specifically for completing a renovation project or constructing a new home, secured by a first or second mortgage. Funds for the entire project are escrowed by the lender at closing, but are released as draws as the project progresses. Once the project is complete, new financing must be secured, which requires a second closing.
Conventional Renovation Financing
Conventional reno financing combines construction financing with permanent financing: the property is automatically refinanced at a predetermined rate on completion of construction. The major advantages of this type of loan are that the client only needs one closing and that the loan amount is based on the value of the home after the project is done. These loans are available both for homes that are already owned and for those that are being newly acquired; the loan amount is typically limited to 80% of the after repair value.
203K loans are conventional reno loans backed by the federal Department of Housing and Urban Development. Because the government guarantees loan repayment to the lender, as much of 105% of the after-repair value of the home may be lent depending on other circumstances. This allows certain projects to be financed that otherwise could not qualify. These loans tend to be a bit more expensive, and require mortgage insurance (MI), which increases the monthly payment.
For more information on 203K financing, click here.
Commercial loans are like convention reno loans for investment property. They typically have somewhat higher interest rates and require a larger down payment than residential loans. However, the income of the borrower usually isn't a factor; the lender secures the loan with the real estate and the personal assets of the borrower. At the end of the construction project, the property must either be sold or refinanced.
Hard Money (Private Lenders)
Hard money loans are like commercial loans -- but with much less red tape. They can often be closed in 1-2 weeks, but come at a much higher cost, usually 12-15% interest and 3-5 points in fees. These are available for investment properties only, and at the end of the construction project, the property must either be sold or refinanced.